Morgan Stanley’s $2.4 billion Facebook short

Matt Levine had a very wonky post on Friday afternoon about the dynamics of the Facebook IPO in general and of the very misunderstood greenshoe option in particular. Now that we’ve all had a nice relaxing weekend, it’s maybe worth revisiting that greenshoe, because it’s actually possible, given Facebook’s tumbling share price today, that Morgan Stanley will make a substantial amount of money on it.

First, it’s worth explaining how the greenshoe option is meant to work. In the IPO, the underwriting banks — there were lots of them, but let’s just call them all “Morgan Stanley”, for simplicity’s sake — sold 484 million shares of Facebook at $38 each. At the same time, they bought 421 million shares of Facebook from the company and its investors, at $37.582 each. The underwriter’s fee of 1.1% is the difference between those two numbers: if you buy at $37.582 and sell at $38, then you end up creaming off 1.1% of the total amount raised.

You’ll note that Morgan Stanley sold more shares than it bought. That’s the greenshoe. When you sell more shares than you buy, you’re short that stock, so when a bank exercises its greenshoe option, as Morgan Stanley did in this case, it is going short the stock in question.

Why would a company like Facebook want its banks to be short its own stock? Partly because when there’s a big short in the market, that provides upward pressure on the share price. Shorts need to cover their short position — which means they need to buy stock. But more generally, the greenshoe is a way to provide the market with a nice extra slug of shares, which everybody wants if the stock trades substantially higher than its IPO price.

The greenshoe does, however, raise certain existential questions — not least, how can 484 million shares be sold, if only 421 million shares have been issued? Do those extra 63 million shares exist?

It’s a good question, and the answer is that they’re in a kind of quantum limbo, a bit like Schrödinger’s cat. In one possible world the shares trade happily on the open market, in which case Morgan Stanley will exercise its option, and force Facebook and its investors* to cough up the last 63 million shares; at that point, they certainly do exist. In another possible world, Morgan Stanley ends up buying back those 63 million shares on the open market, thereby reducing the number of shares actually trading to the original 421 million. In that world, the 63 million shares never had much of an existence: they were sold by Morgan Stanley and then bought back by Morgan Stanley, and all that’s left at the end of the day is nothing.

Given where Facebook is trading right now, you can be sure that Morgan Stanley will not exercise its option, Facebook and its investors will not issue those extra 63 million shares, and that in a few days’ time, the free float of Facebook shares will be 421 million, not 484 million.

Which in turn means that over the course of the first two or three trading sessions, Morgan Stanley will have ended up buying 63 million shares of Facebook on the open market. It sold those shares at $38, remember. So its total profit on the greenshoe operation will be zero if it bought all 63 million shares at $38 exactly. If it bought some of the shares above $38, then it could end up making a loss. And if it ends up buying a slug of shares below $38, then it’ll end up making a profit. That’s what happens, when you go short at $38 and then buy back at, say, $34.

This is a very big trade: 63 million shares at $38 each comes to $2.4 billion. On the other hand, there’s very little doubt that Morgan Stanley was doing a lot of buying on Friday. 43 million shares were bought at $38.00 exactly, and another 28.5 million shares were bought at $38.01. It’s reasonable to assume that most if not all of that buying came from Morgan Stanley, supporting the share price.

So the chances are that at the end of the day, Morgan Stanley is going to end up pretty flat on its trade, selling the shares at $38 and then buying them back at $38. But if it bought more than 63 million shares on Friday, then it is sitting on a substantial mark-to-market loss right now. And similarly, if it bought back fewer than 63 million shares on Friday, then it’s actually making a profit on its greenshoe short.

Chances are, no one outside the company will ever know for sure what Morgan Stanley’s P&L on the Facebook IPO ends up looking like. But it would make sense, if Morgan Stanley saw a lot of selling pressure on Friday, for the bank to keep onto at least a little bit of its short position into Monday morning. At which point it could make a tidy profit on that plunging share price.

*In this case, it’s actually just the investors: Facebook wasn’t participating in the greenshoe scheme. But it could have, if it had wanted to.

The greenshoe is a non-zero-sum way of adding value with optimal risk-shifting: it takes some uncertainty about aftermarket performance from skittish investors and gives it, in the form of uncertainty about deal size, to an issuer who is probably better able to bear it (because selling 15% more shares at the price you agreed on three days ago is rarely a tragedy). The structure of the greenshoe, though, adds an additional conflict, in that banks can hoard the value of the greenshoe for themselves rather than spending it on their investor clients. The fact that they basically don’t do that suggests that motive and opportunity aren’t everything: sometimes banks just do the right thing for capital allocation and risk shifting, even when they could make more money doing the wrong thing.